Introduction to Taxation Solutions

1. Some tax considerations Aqua should investigate include the following: • State and local income taxes. • State and local sales taxes. • State and local property taxes. Many such taxes could affect any cost-of-living differential. pp. 1-5, 1-11, 1-12, and 1-16 2. Except for the Federal estate and gift taxes, all excise taxes are proportional. This is also the case with ad valorem property taxes. Besides the Federal estate and gift taxes, income taxes are progressive. pp. 1-3 and 1-15 3. As the Medicare tax component of the FICA tax rate is constant, the tax is proportional.

pp. 1-3, 1-8, and Example 3 4. a. The FICA tax burden is shared by both employer and employee, while the incidence of FUTA falls entirely on the employer. pp. 1-7 and 1-8 b. The justification for FICA is to provide retirement and disability security. FUTA, on the other hand, is designed to provide modest unemployment benefits. pp. 1-7 and 1-8 c. For 2004, the FICA tax rate on employees and employers is 6. 2 percent of wages up to a maximum base amount of $87,900 and 1. 45 percent on all wages (no limit). FUTA applies at a maximum rate of 6.

2 percent on the first $7,000 of covered wages. pp. 1-7 and 1-8 5. Jim probably will be required to pay the Washington use tax if, and when, he applies for Washington license plates. In this case, the use tax probably is the same amount as the Washington sales tax. p. 1-6 and Example 5 6. Since the gift tax is cumulative in effect, the 2002 taxable gift must be added to the 2004 taxable gift. As the tax rates are progressive, the tax on $500,000 is $155,800. From this amount is subtracted the amount paid on the 2002 gift.

Thus, $85,000 ($155,800 – $70,800) is the amount of tax due on the 2004 gift. p. 1-10 and Example 11 7. 16 (donees) X $11,000 (annual exclusion) X 10 years = $1,760,000. p. 1-10 and Example 13 8. Because the property is no longer being used for religious purposes, the downtown location should no longer be exempt from ad valorem taxes. Also, the church would have an income tax problem (unrelated business income) with the lease payment it receives. p. 1-11 9. In all probability, the residence was not on the property tax rolls when it was owned by a tax-exempt organization (i.e. , St. Matthew’s Catholic Church)—see p. 1-11 in the text.

Also clear is the fact that the taxing authority is not aware that the residence is no longer owned by a tax-exempt organization. Since it is only a question of time before the omission is noticed by the taxing authority, it would be advisable for the Toth’s to get the matter cleared up. In many cases, further delay can lead to additional interest and penalties. pp. 1-11 and 1-12 10. Gull Company is trying to minimize the value of the real estate. This can be done by keeping personalty from becoming a “fixture.

” The jurisdiction where the building is situated probably imposes an ad valorem tax on realty that is higher than that imposed on personalty. pp. 1-11 and 1-12 11. Ricky Williams moved from a state with an income tax (Louisiana) to one without an income tax (Florida). Consequently, all of his home games will not generate any state income tax. As to the away games, he is vulnerable if the host city and state has an income tax. Thus, his situation was identical to that of Alex Rodriguez (A-Rod) discussed in the Tax in the News on p. 1-17.

When Ricky played for the Saints, he could claim some credit against his Louisiana income tax for the out-of-state income taxes paid on the away games. Now this is no longer necessary because of the absence of a Florida income tax. Thus, the possibility of more than one state taxing the same income is avoided. pp. 1-15 and 1-16 12. Walt probably is continuing to make use of his mother’s senior citizen exemption for ad valorem tax purposes. pp. 1-11 and 1-12 13. a. “Generous” probably means a prolonged exemption from ad valorem property taxes.

b. A new business brings more families into the area. This, in turn, means more children to educate. While costs increase, the tax holiday could mean a loss of tax revenue. p. 1-12 14. In some states, counties (and cities) are given the option to impose additional sales tax levies. It is possible that this is the situation with Wilson County. If so, this would explain why Velma does her shopping in Grimes County. p. 1-5 and Example 4 15. Earl probably purchased his computer out-of-state by use of a catalog or through the Internet.

In such cases, state collection of the sales (use) tax is improbable without taxpayer compliance. p. 1-6 16. Paul undoubtedly purchased some items (e. g. , drugs) that are excluded from the purview of the applicable general sales tax. p. 1-5 17. a. Using the individual income tax formula in Figure 1-1, Jill’s taxable income is computed as follows: Income broadly conceived $220,000 Less: exclusions (30,000) Gross income$190,000 Less: deductions for AGI (38,000) AGI$152,000 Less: greater of Itemized deductions 20,000 Standard deduction 4,850 (20,000).

Less: personal exemption (3,100) Taxable income$128,900 ======= Using the Tax Rate Schedule X inside the front cover of the textbook, Jill’s total tax liability for 2004 would be $30,719 ($14,325 + 0. 28 [$128,900 – $70,350]). This tax liability of $30,719 would then be reduced by the tax credits of $19,000 to $11,719. The $4,781 excess of estimated tax payments of $16,500 over the $11,719 could be refunded or applied to the next year’s tax liability. b. If Jill were a corporation, her taxable income would be computed using the formula in Figure 1-1, as follows:

Income broadly conceived$220,000 Less: exclusions(30,000) Gross income$190,000 Less: deductions(58,000) Taxable income $132,000 Note that the corporation receives no personal exemption and that no distinction is made between deductions for and from AGI. Using the corporate tax rate schedule inside the front cover of the textbook, Jill’s total tax liability for 2004 is $34,730. $50,000 X 15% = $ 7,500 25,000 X 25% = 6,250 25,000 X 34% = 8,500 32,000X 39% = 12,480 $34,730 This tax liability would then be reduced by the tax credits of $19,000 to $15,730 ($34,730 – $19,000).

The $770 excess of estimated tax payments of $16,500 over the $15,730 could be refunded or applied to next year’s tax liability. pp. 1-14 and 1-15 18. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 February 25, 2004 Cynthia Clay 1206 Seventh Avenue Fort Worth, TX 76101 Dear Cynthia: I am writing this letter to help you decide on what form of entity to choose for your new sandwich delivery business. In our phone conversation, you indicated that you expect to have losses for the first two years in this business and then make substantial profits in subsequent years.

You and Cory also indicated that you are concerned about potential personal liability. While I can’t make a conclusive recommendation based on the information you have given me, I can provide you with some general guidelines that should simplify your decision. First, given your concern about personal liability, a partnership does not appear to be a desirable option (you would both be personally liable for any injuries to customers). Similarly, given your expectation of losses in the first two years, it does not appear that a regular “C” corporation would be a desirable choice, at least initially.

This is because any losses in the corporation could only be used to offset future corporate profits—you could not use the losses to immediately offset your personal tax liability. Thus, two choices exist which provide limited liability and deductibility of losses on your personal income tax return. These are the “S” corporation and the limited liability company. If you choose an “S” corporation, we would probably convert the entity to a “C” corporation when the business becomes profitable. At that point, profits would be taxed at the regular “C” corporation rates.

A second tax would be levied on your personal income tax return for any dividends paid by the corporation once it achieves “C” status. In contrast, limited liability companies are taxed like partnerships—all income would be taxed on your personal income tax return in profitable years. The relative desirability of each of these two forms depends on a number of factors. One of the most important factors in your situation is the relationship between your personal tax rate and the tax rate of a regular “C” corporation.

If you are in a high tax bracket and if the income in the business is sufficiently low, you might be best off choosing the “S” corporation. Alternatively, if you expect the business to generate a sufficiently large profit each year, it might be best to choose the limited liability company. If you would like me to give you a clearer recommendation, we should meet at your earliest convenience. If you have any additional questions, please call me. Best regards, Julian Jackson, CPA pp. 1-16 to 1-19 19. a. | |2003 |2004 |2005 | |Corporate Tax Liability |.

| | | |Sales Revenue |$150,000 |$320,000 |$600,000 | |Cash Expenses |(30,000) |(58,000) |(95,000) | |Depreciation |(25,000) |(20,000) |(40,000) | |Taxable Income |$95,000 |$242,000 |$465,000 | |Corporate Tax Liability |$20,550 |$ 77,630 |$158,100 | | | | | | | | | | | | | | | | |Cash Available for Dividends | | | | |Sales Revenue |$150,000 |$320,000 |$600,000 | |Tax-Free Interest Income |5,000 |8,000 |15,000 | |Cash Expenses |(30,000) |(58,000) |(95,000) | |Corporate Tax Liability |(20,550) |(77,630) |(158,100) | |

Cash Available for Dividends |$104,450 |$192,370 |$361,900 | | | | | | |Ashley’s After-Tax Cash Flow | | | | |Dividend Received |$104,450 |$192,370 |$361,900 | |Tax on Dividend at 15% rounded |(15,668) |(28,856) |(54,285) | |After-Tax Cash Flow |$ 88,782 |$163,514 |$307,615 | |PV of Cash Flow* | $ 80,712 |$135,128 |$231,111 | |Present Value |$446,951 | | | * Present value factors (. 9091, . 8264, . 7513) from Appendix F. b.

| | 2003 | 2004 | 2005 | |Individual Tax Liability | | | | |Sales Revenue |$150,000 |$320,000 |$600,000 | |Cash Expenses |(30,000) |(58,000) |(95,000) | |Depreciation |(25,000) |(20,000) |(40,000) | |Taxable Income |$ 95,000 |$242,000 |$465,000 | |Individual Tax Liability** |$ 33,250 |$ 84,700 |$162,750 | |** Rate = 35% | | | | | | | | | |Ashley’s After-Tax Cash Flow | | | | |Sales Revenue |$150,000 |$320,000 |$600,000 | |Tax-Free Interest Income |5,000 | 8,000 |15,000 | |Cash Expenses |(30,000) |(58,000) |(95,000) | |Individual Tax Liability |(33,250) |(84,700) |(162,750) | |After-Tax Cash Flow |$ 91,750 |$185,300 |$357,250 | |PV of Cash Flow |$ 83,410 |$153,132 |$268,402 | |Present Value |$504,944 | | | c.

If Ashley wants to have access to all available cash from the business, then she will have to pay out dividends annually. As seen in the answers to a and b above, the present value of future cash flows is substantially greater if she does not incorporate under this assumption. Alternatively, if she does not need to pay out dividends, then she may be better off by incorporating, since only the corporate tax will be incurred ($256,280), which is less than her individual tax ($280,700). The value of her stock will increase and she can then sell the stock at a later date at favorable capital gains rates. pp. 1-16 to 1-19 20. a. The implicit tax rate on the Kiowa County bonds is (8% – 5%) / 8%, or 37. 5%.

Implicit tax can be thought of as the tax rate that would generate the tax-free return if it were applied to the taxable bond. b. Given that Sienna only faces a 25% marginal tax rate, the tax-free bonds would not be a good investment because the implicit tax rate is too high. p. 1-27 and Example 36 21. Without the new product line, Chartreuse would offset all of its 2004 and 2005 income with the NOL carryforward and would have no regular tax liability until 2005. With the new product line, Chartreuse would have taxable income of $20,000 ($50,000 income – $30,000 NOL carryforward) in 2005. That is, all $70,000 of 2004 income would be offset by the NOL carryforward and $30,000 of the 2005 income would be offset.

Assuming no changes in corporate tax rates, Chartreuse would face a 0% tax rate in 2004 and a 15% tax rate in 2005 if the new product line were chosen versus a 0% tax rate if the line were not chosen. The tax rate faced in 2005 in the new product line would be the discounted value of the 15% rate over one year. For example, assuming a 10% discount rate, the tax rate would be 13. 6% (15% / 1. 1). pp. 1-26, 1-27, and Example 35 22. Using the corporate tax rate schedule inside the cover of the textbook, Mauve’s tax liability (on $105,000) is $24,200. Since Mauve would pay $0. 39 on the next dollar of taxable income earned, its marginal tax rate is 39%.

Its average tax rate is the ratio of tax liability to taxable income or approximately 23% ($24,200 / $105,000). Its effective tax rate is the ratio of tax liability to total income or approximately 20% ($24,200 / $120,000). p. 1-26 and Example 34 23. The purpose of the annual exclusion is to avoid the need to report and pay taxes on modest gifts. Without the exclusion, the IRS could have a real problem of taxpayer noncompliance. p. 1-34 24. a. Economic considerations—encouragement of certain activities. In this case, the stimulation of U. S. export of services. p. 1-28 b. Economic considerations—encouragement of small business. What is described is the election under Subchapter S of the Code. p. 1-30 c. Social considerations.

By making the premium deductible by the employer and largely nontaxable to the employee, these plans are encouraged. p. 1-30 d. Equity considerations—mitigation of the annual accounting period concept. p. 1-32 25. The encouragement of home ownership is largely a social consideration. However, the equitable aspects of providing the home owner a tax benefit that is not available to one who rents is subject to criticism. p. 1-30 26. a. To encourage pension plans is to stimulate saving (economic consideration). Also, it provides security from the private sector for retirement to supplement rather meager public programs (social considerations). pp. 1-28 and 1-30 b. To make education more widely available is to promote a socially desirable objective.

A better educated work force also serves to improve the country’s economic capabilities. Thus, education tax incentives can be justified on both social and economic grounds. p. 1-30 c. The encouragement of home ownership can be justified on both social and economic grounds. p. 1-30 d. The deferral of gain on an installment sale can be justified under the wherewithal to pay notion and to mitigate the effect of the annual accounting period concept. p. 1-32 e. Unearned income is taxed in the year received based on administrative feasibility and the wherewithal to pay concept. p. 1-34 27. a. Justin’s realized gain on the transaction is $120,000 [$140,000 (condemnation award – $20,000 (cost of the land)].

His recognized gain is the lower of the realized gain of $120,000 or the amount of the condemnation proceeds not reinvested ($140,000 – $15,000 = $125,000). b. As all of the award is reinvested, no gain is recognized. c. $10,000 of the gain must be recognized, the excess of the condemnation award over the amount reinvested. pp. 1-31, 1-32, Examples 37 and 38 28. The installment method of recognizing gain on the sale of property allows a taxpayer to spread the tax consequences over the payout period. The harsh effect of taxing all of the gain in the year of sale is thereby avoided. p. 1-32 29. Indexation is provided for various components of the Federal income tax structure (e. g. , tax rates and personal exemptions). p. 1-33 30.

The Internet Activity research problems require that the student access various sites on the Internet. Thus, each student’s solution likely will vary from that of the others. You should determine the skill and experience levels of the students before making the assignment, coaching them where necessary so as to broaden the scope of the exercise to the entire available electronic world. Make certain that you encourage students to explore all parts of the World Wide Web in this process, including the key tax sites, but also information found through the web sites of newspapers, magazines, businesses, tax professionals, government agencies, political outlets, and so on.

They should work with Internet resources other than the Web as well, including newsgroups and other interest-oriented lists. Build interaction into the exercise wherever possible, asking the student to send and receive e-mail in a professional and responsible manner. 31. Although a certain amount of noncompliance can be expected to arise in both forms of taxation, the national sales tax will generate greater opportunity. Since only the ultimate retailer is responsible for collecting the national sales tax, it is more easily circumvented. In the case of a VAT, however, complete avoidance usually requires the collusion of multiple parties. pp. 1-5 and 1-6 BRIDGE DISCIPLINE PROBLEM 1. Answer will vary with each student. NOTES.